Download 2 Supply and Demand I

Econ 200 Fall 2012
• Microeconomics
• Opportunity Cost and the Gains from Trade
• Supply and Demand
• Firms and Industries
• Macroeconomics
• The Data of Macroeconomics
• Growth Saving and Investment
• Money and Exchange Rates
REFERENCE: Chapters 4 – 6 in your text.
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MARKETS AND COMPETITION
• A market is a group of buyers and sellers of a
particular good or service.
• The terms supply and demand refer to the
behaviour of people . . . as they interact with
one another in markets.
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MARKETS AND COMPETITION
• Buyers determine demand.
• Sellers determine supply
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Competitive Markets
• A competitive market is a market in which there
are many buyers and sellers so that each has a
negligible impact on the market price.
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Competition: Perfect and Otherwise
• Perfect Competition
• Products are the same
• Numerous buyers and sellers so that each has no
influence over price
• Buyers and Sellers are price takers
• Monopoly
• One seller, and seller controls price
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Competition: Perfect and Otherwise
• Oligopoly
• Few sellers
• Not always aggressive competition
• Monopolistic Competition
• Many sellers
• Slightly differentiated products
• Each seller may set price for its own product
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DEMAND
• Quantity demanded is the amount of a good that
buyers are willing and able to purchase.
• Law of Demand
• The law of demand states that, other things equal,
the quantity demanded of a good falls when the
price of the good rises.
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The Demand Curve: The Relationship
between Price and Quantity Demanded
• Demand Schedule
• The demand schedule is a table that shows the
relationship between the price of the good and the
quantity demanded.
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Catherine’s Demand Schedule
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The Demand Curve: The Relationship
between Price and Quantity Demanded
• Demand Curve
• The demand curve is a graph of the relationship
between the price of a good and the quantity
demanded.
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Figure 1 Catherine’s Demand Schedule and Demand
Curve
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Market Demand versus Individual Demand
• Market demand refers to the sum of all
individual demands for a particular good or
service.
• Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
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Shifts in the Demand Curve
• Change in Quantity Demanded
• Movement along the demand curve.
• Caused by a change in the price of the product.
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Changes in Quantity Demanded
Price of IceCream
Cones
B
€2.00
A tax that raises the
price of ice-cream
cones results in a
movement along the
demand curve.
A
€1.00
D
0
4
8
Quantity of Ice-Cream Cones
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Shifts in the Demand Curve
•
•
•
•
•
Consumer income
Prices of related goods
Tastes
Expectations
Number of buyers
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Shifts in the Demand Curve
• Change in Demand
• A shift in the demand curve, either to the left or
right.
• Caused by any change that alters the quantity
demanded at every price.
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Figure 3 Shifts in the Demand Curve
Price of
Ice-Cream
Cone
Increase
in demand
Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0
Quantity of
Ice-Cream Cones
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Shifts in the Demand Curve
• Consumer Income
• As income increases the demand for a normal good
will increase.
• As income increases the demand for an inferior
good will decrease.
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Consumer Income
Normal Good
Price of IceCream Cone
€ 3.00
An increase
in income...
2.50
Increase
in demand
2.00
1.50
1.00
0.50
D1
0 1
2 3 4 5 6 7 8 9 10 11 12
D2
Quantity of
Ice-Cream
Cones
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Consumer Income
Inferior Good
Price of IceCream Cone
€ 3.00
2.50
An increase
in income...
2.00
Decrease
in demand
1.50
1.00
0.50
D2
0 1
D1
2 3 4 5 6 7 8 9 10 11 12
Quantity of
Ice-Cream
Cones
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Shifts in the Demand Curve
• Prices of Related Goods
• When a fall in the price of one good reduces the
demand for another good, the two goods are called
substitutes.
• When a fall in the price of one good increases the
demand for another good, the two goods are called
complements.
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Table 1 Variables That Influence Buyers
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SUPPLY
• Quantity supplied is the amount of a good that
sellers are willing and able to sell.
• Law of Supply
• The law of supply states that, other things equal, the
quantity supplied of a good rises when the price of
the good rises.
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The Supply Curve: The Relationship between
Price and Quantity Supplied
• Supply Schedule
• The supply schedule is a table that shows the
relationship between the price of the good and the
quantity supplied.
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Ben’s Supply Schedule
Supplied
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The Supply Curve: The Relationship between
Price and Quantity Supplied
• Supply Curve
• The supply curve is the graph of the relationship
between the price of a good and the quantity
supplied.
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Figure 5 Ben’s Supply Schedule and Supply Curve
Supplied
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Market Supply versus Individual Supply
• Market supply refers to the sum of all
individual supplies for all sellers of a particular
good or service.
• Graphically, individual supply curves are
summed horizontally to obtain the market
supply curve.
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Shifts in the Supply Curve
•
•
•
•
Input prices
Technology
Expectations
Number of sellers
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Shifts in the Supply Curve
• Change in Quantity Supplied
• Movement along the supply curve.
• Caused by a change in anything that alters the
quantity supplied at each price.
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Change in Quantity Supplied
Price of IceCream
Cone
S
C
€3.00
€1.00
0
A rise in the price
of ice cream
cones results in a
movement along
the supply curve.
A
1
5
Quantity of
Ice-Cream
Cones
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Shifts in the Supply Curve
• Change in Supply
• A shift in the supply curve, either to the left or right.
• Caused by a change in a determinant other than
price.
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Figure 7 Shifts in the Supply Curve
Price of
Ice-Cream
Cone
Supply curve, S3
Decrease
in supply
Supply
curve, S1
Supply
curve, S2
Increase
in supply
0
Quantity of
Ice-Cream Cones
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Table 2 Variables That Influence Sellers
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SUPPLY AND DEMAND
TOGETHER
• Equilibrium refers to a situation in which the
price has reached the level where quantity
supplied equals quantity demanded.
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SUPPLY AND DEMAND
TOGETHER
• Equilibrium Price
• The price that balances quantity supplied and
quantity demanded.
• On a graph, it is the price at which the supply and
demand curves intersect.
• Equilibrium Quantity
• The quantity supplied and the quantity demanded at
the equilibrium price.
• On a graph it is the quantity at which the supply and
demand curves intersect.
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SUPPLY AND DEMAND
TOGETHER
Demand Schedule
Supply Schedule
0
0
1
4
7
10
13
At €2.00, the quantity demanded
is equal to the quantity supplied!
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Figure 8 The Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
€ 2.00
Equilibrium
Equilibrium price
Equilibrium
quantity
0
1
2
3
4
5
6
7
8
Demand
9 10 11 12 13
Quantity of Ice-Cream Cones
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Figure 9 Markets Not in Equilibrium
(a) Excess Supply
Price of
Ice-Cream
Cone
Supply
Surplus
€ 2.50
2.00
Demand
0
4
Quantity
demanded
7
10
Quantity
supplied
Quantity of
Ice-Cream
Cones
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Equilibrium
• Surplus
• When price > equilibrium price, then quantity
supplied > quantity demanded.
• There is excess supply or a surplus.
• Suppliers will lower the price to increase sales, thereby
moving toward equilibrium.
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Equilibrium
• Shortage
• When price < equilibrium price, then quantity
demanded > the quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many buyers
chasing too few goods, thereby moving toward
equilibrium.
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Figure 9 Markets Not in Equilibrium
(b) Excess Demand
Price of
Ice-Cream
Cone
Supply
€ 2.00
1.50
Shortage
Demand
0
4
Quantity
supplied
7
10
Quantity of
Quantity
Ice-Cream
demanded
Cones
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Equilibrium
• Law of supply and demand
• The claim that the price of any good adjusts to bring
the quantity supplied and the quantity demanded for
that good into balance.
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Three Steps to Analyzing Changes in
Equilibrium
• Decide whether the event shifts the supply or
demand curve (or both).
• Decide whether the curve(s) shift(s) to the left
or to the right.
• Use the supply and demand diagram to see how
the shift affects equilibrium price and quantity.
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Figure 10 How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream
Cone
1. Hot weather increases
the demand for ice cream . . .
Supply
€ 2.50
New equilibrium
2.00
2. . . . resulting
in a higher
price . . .
Initial
equilibrium
D
D
0
7
3. . . . and a higher
quantity sold.
10
Quantity of
Ice-Cream Cones
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Three Steps to Analyzing Changes in
Equilibrium
• Shifts in Curves versus Movements along
Curves
• A shift in the supply curve is called a change in
supply.
• A movement along a fixed supply curve is called a
change in quantity supplied.
• A shift in the demand curve is called a change in
demand.
• A movement along a fixed demand curve is called a
change in quantity demanded.
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Figure 11 How a Decrease in Supply Affects the
Equilibrium
Price of
Ice-Cream
Cone
S2
1. An increase in the
price of sugar reduces
the supply of ice cream. . .
S1
New
equilibrium
€ 2.50
Initial equilibrium
2.00
2. . . . resulting
in a higher
price of ice
cream . . .
Demand
0
4
7
3. . . . and a lower
quantity sold.
Quantity of
Ice-Cream Cones
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Table 4 What Happens to Price and Quantity When Supply
or Demand Shifts?
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Review
• Economists use the model of supply and
demand to analyze competitive markets.
• In a competitive market, there are many buyers
and sellers, each of whom has little or no
influence on the market price.
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Review
• The demand curve shows how the quantity of a
good depends upon the price.
• According to the law of demand, as the price of a
good falls, the quantity demanded rises. Therefore,
the demand curve slopes downward.
• In addition to price, other determinants of how
much consumers want to buy include income, the
prices of complements and substitutes, tastes,
expectations, and the number of buyers.
• If one of these factors changes, the demand curve
shifts.
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Review
• The supply curve shows how the quantity of a
good supplied depends upon the price.
• According to the law of supply, as the price of a
good rises, the quantity supplied rises. Therefore,
the supply curve slopes upward.
• In addition to price, other determinants of how
much producers want to sell include input prices,
technology, expectations, and the number of sellers.
• If one of these factors changes, the supply curve
shifts.
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Review
• Market equilibrium is determined by the
intersection of the supply and demand curves.
• At the equilibrium price, the quantity demanded
equals the quantity supplied.
• The behaviour of buyers and sellers naturally
drives markets toward their equilibrium.
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Review
• To analyze how any event influences a market,
we use the supply and demand diagram to
examine how the even affects the equilibrium
price and quantity.
• In market economies, prices are the signals that
guide economic decisions and thereby allocate
resources.
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Mini Quiz
Market for CD Players
Price
Quantity Demanded
Quantity Supplied
100
1000
100
150
900
300
200
800
500
250
600
600
300
500
650
Refer to the Table above. Given this data, the equilibrium price and quantity of CD players are
a. €150 and 300 players.
b. €200 and 800 players.
c. €250 and 600 players.
d. €300 and 650 players.
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Mini Quiz
If a drought destroyed half of the French garlic crop at a time when the health
benefits of garlic were being well publicized, economists would expect that in the
market for garlic
a. quantity exchanged would rise but the change in price is uncertain without
further information.
b. price would rise but the change in quantity exchanged is uncertain without
further information.
c. both price and quantity exchanged would rise.
d. price would rise and quantity exchanged would fall.
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Elasticity . . .
• … allows us to analyze supply and demand
with greater precision.
• … is a measure of how much buyers and sellers
respond to changes in market conditions
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THE ELASTICITY OF DEMAND
• Price elasticity of demand is a measure of how
much the quantity demanded of a good
responds to a change in the price of that good.
• Price elasticity of demand is the percentage
change in quantity demanded given a percent
change in the price.
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The Price Elasticity of Demand and Its
Determinants
•
•
•
•
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon
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The Price Elasticity of Demand and Its
Determinants
• Demand tends to be more elastic :
•
•
•
•
the larger the number of close substitutes.
if the good is a luxury.
the more narrowly defined the market.
the longer the time period.
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Computing the Price Elasticity of Demand
• The price elasticity of demand is computed as
the percentage change in the quantity demanded
divided by the percentage change in price.
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
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Computing the Price Elasticity of Demand
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
• Example: If the price of an ice cream cone
increases from €2.00 to €2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:
(10  8)
 100
20%
10

2
(2.20  2.00)
 100 10%
2.00
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The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
• The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer regardless of
the direction of the change.
(Q2  Q1 ) / [(Q2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]
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The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
• Example: If the price of an ice cream cone
increases from €2.00 to €2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint
formula, would be calculated as:
(10  8)
22%
(10  8) / 2

 2.32
(2.20  2.00)
9.5%
(2.00  2.20) / 2
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The Variety of Demand Curves
• Inelastic Demand
• Quantity demanded does not respond strongly to
price changes.
• Price elasticity of demand is less than one.
• Elastic Demand
• Quantity demanded responds strongly to changes in
price.
• Price elasticity of demand is greater than one.
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Computing the Price Elasticity of Demand
(100 - 50)
(100  50)/2
ED 
(4.00 - 5.00)
(4.00  5.00)/2
Price
€5
4
0
67 percent

 -3
- 22 percent
Demand
50
100 Quantity
Demand is price elastic
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The Variety of Demand Curves
• Perfectly Inelastic
• Quantity demanded does not respond to price
changes.
• Perfectly Elastic
• Quantity demanded changes infinitely with any
change in price.
• Unit Elastic
• Quantity demanded changes by the same percentage
as the price.
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The Variety of Demand Curves
• Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related to the
slope of the demand curve.
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Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
€5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
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South-Western
Learning
Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
€5
4
1. A 22%
increase
in price . . .
Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
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South-Western
Learning
Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
€5
4
Demand
1. A 22%
increase
in price . . .
0
80
100
Quantity
2. . . . leads to a 22% decrease in quantity demanded.
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South-Western
Learning
Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
€5
4
Demand
1. A 22%
increase
in price . . .
0
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
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South-Western
Learning
Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above €4, quantity
demanded is zero.
€4
Demand
2. At exactly €4,
consumers will
buy any quantity.
0
3. At a price below €4,
quantity demanded is infinite.
Quantity
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South-Western
Learning
Total Revenue and the Price Elasticity of
Demand
• Total revenue is the amount paid by buyers and
received by sellers of a good.
• Computed as the price of the good times the
quantity sold.
TR = P x Q
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Figure 2 Total Revenue
Price
€4
P × Q = €400
(revenue)
P
0
Demand
100
Quantity
Q
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South-Western
Learning
Elasticity and Total Revenue along a Linear
Demand Curve
• With an inelastic demand curve, an increase in
price leads to a decrease in quantity that is
proportionately smaller. Thus, total revenue
increases.
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Figure 3 How Total Revenue Changes When Price
Changes: Inelastic Demand
Price
Price
An Increase in price from €1
to €3 …
… leads to an Increase in
total revenue from €100 to
€240
€3
Revenue = €240
€1
Demand
Revenue = €100
0
100
Quantity
Demand
0
80
Quantity
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South-Western
Learning
Elasticity and Total Revenue along a Linear
Demand Curve
• With an elastic demand curve, an increase in
the price leads to a decrease in quantity
demanded that is proportionately larger. Thus,
total revenue decreases.
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Figure 4 How Total Revenue Changes When Price
Changes: Elastic Demand
Price
Price
An Increase in price from €4
to €5 …
… leads to an decrease in
total revenue from €200 to
€100
€5
€4
Demand
Demand
Revenue = €200
0
50
Revenue = €100
Quantity
0
20
Quantity
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South-Western
Learning
Elasticity of a Linear Demand Curve
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Income Elasticity of Demand
• Income elasticity of demand measures how
much the quantity demanded of a good
responds to a change in consumers’ income.
• It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
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Computing Income Elasticity
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
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Income Elasticity
• Types of Goods
• Normal Goods
• Inferior Goods
• Higher income raises the quantity demanded for
normal goods but lowers the quantity demanded
for inferior goods.
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Income Elasticity
• Goods consumers regard as necessities tend to
be income inelastic
• Examples include food, fuel, clothing, utilities, and
medical services.
• Goods consumers regard as luxuries tend to be
income elastic.
• Examples include sports cars, furs, and expensive
foods.
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THE ELASTICITY OF SUPPLY
• Price elasticity of supply is a measure of how
much the quantity supplied of a good responds
to a change in the price of that good.
• Price elasticity of supply is the percentage
change in quantity supplied resulting from a
percent change in price.
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Figure 6 The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Supply
€5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity supplied unchanged.
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South-Western
Learning
Figure 6 The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
€5
4
1. A 22%
increase
in price . . .
0
100
110
Quantity
2. . . . leads to a 10% increase in quantity supplied.
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South-Western
Learning
Figure 6 The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
€5
4
1. A 22%
increase
in price . . .
0
100
125
Quantity
2. . . . leads to a 22% increase in quantity supplied.
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South-Western
Learning
Figure 6 The Price Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply
€5
4
1. A 22%
increase
in price . . .
0
100
200
Quantity
2. . . . leads to a 67% increase in quantity supplied.
Copyright
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South-Western
Learning
Figure 6 The Price Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above €4, quantity
supplied is infinite.
€4
Supply
2. At exactly €4,
producers will
supply any quantity.
0
3. At a price below €4,
quantity supplied is zero.
Quantity
Copyright
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South-Western
Learning
Determinants of Elasticity of Supply
• Ability of sellers to change the amount of the
good they produce.
• Beach-front land is inelastic.
• Books, cars, or manufactured goods are elastic.
• Time period.
• Supply is more elastic in the long run.
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Computing the Price Elasticity of Supply
• The price elasticity of supply is computed as
the percentage change in the quantity supplied
divided by the percentage change in price.
Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price
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THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
• Can good news for farming be bad news for
farmers?
• What happens to wheat farmers and the market
for wheat when scientists discover a new wheat
hybrid that is more productive than existing
varieties?
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THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
• Examine whether the supply or demand curve
shifts.
• Determine the direction of the shift of the
curve.
• Use the supply and demand diagram to see how
the market equilibrium changes.
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Figure 8 An Increase in Supply in the Market for Wheat
Price of
Wheat
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
S1
S2
€3
2
Demand
0
100
110
Quantity of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from €300 to €220.
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South-Western
Learning
Compute the Price Elasticity of Supply
100  110
(100  110) / 2
ED 
3.00  2.00
(3.00  2.00) / 2
0.095

 0.24
0.4
Supply is price inelastic
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Review
• Price elasticity of demand measures how much
the quantity demanded responds to changes in
the price.
• Price elasticity of demand is calculated as the
percentage change in quantity demanded
divided by the percentage change in price.
• If a demand curve is elastic, total revenue falls
when the price rises.
• If it is inelastic, total revenue rises as the price
rises.
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Review
• The income elasticity of demand measures how
much the quantity demanded responds to
changes in consumers’ income.
• The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
• The price elasticity of supply measures how
much the quantity supplied responds to changes
in the price.
Copyright © 2010 Cengage Learning
Review
• In most markets, supply is more elastic in the
long run than in the short run.
• The price elasticity of supply is calculated as
the percentage change in quantity supplied
divided by the percentage change in price.
• The tools of supply and demand can be applied
in many different types of markets.
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Mini Quiz
1. If price elasticity of demand is 2.0, this implies that consumers would:
a. buy twice as much of the good if price falls by 10 per cent.
b.require a 2 per cent cut in price to raise quantity demanded of the good by 1 per cent.
c.buy 2 per cent more of the good in response to a 1 per cent cut in price.
d.require at least a €2 increase in price before showing any response to the price increase.
2. If Weiskamp T-Shirt Co. lowers its price from €6 to €5 and finds that students increase
their quantity demanded from 400 to 600 T-shirts, then the demand for Weiskamp Tshirts within this price range is
a. price inelastic.
b. price elastic.
c. unit elastic.
d. cross elastic.
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Mini Quiz
3. As a result of heavy spring rains in France, the wheat crop declined sharply. If wheat
growers experienced an increase in sales revenue, the demand for wheat must be
a. price elastic.
b. price inelastic.
c. unitary elastic.
d. perfectly inelastic.
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Supply, Demand, and Government
Policies
• In a free, unregulated market system, market
forces establish equilibrium prices and
exchange quantities.
• While equilibrium conditions may be efficient,
it may be true that not everyone is satisfied.
• One of the roles of economists is to use their
theories to assist in the development of policies.
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CONTROLS ON PRICES
• Are usually enacted when policymakers believe
the market price is unfair to buyers or sellers.
• Result in government-created price ceilings and
floors.
• Price Ceiling
• A legal maximum on the price at which a good can
be sold.
• Price Floor
• A legal minimum on the price at which a good can
be sold.
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How Price Ceilings Affect Market Outcomes
• Two outcomes are possible when the
government imposes a price ceiling:
• The price ceiling is not binding if set above the
equilibrium price.
• The price ceiling is binding if set below the
equilibrium price, leading to a shortage.
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Figure 1 A Market with a Price Ceiling
(a) A Price Ceiling That Is Not Binding
Price of
Ice-Cream
Cone
Supply
€4
Price
ceiling
3
Equilibrium
price
Demand
0
100
Equilibrium
quantity
Quantity of
Ice-Cream
Cones
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Figure 1 A Market with a Price Ceiling
(b) A Price Ceiling That Is Binding
Price of
Ice-Cream
Cone
Supply
Equilibrium
price
€3
2
Price
ceiling
Shortage
Demand
0
75
125
Quantity
supplied
Quantity
demanded
Quantity of
Ice-Cream
Cones
Copyright
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South-Western
Learning
How Price Ceilings Affect Market Outcomes
• Effects of Price Ceilings
• A binding price ceiling creates
• shortages because QD > QS.
• Example: Rent controls in New York restrict new
building
• non-price rationing
• Examples: Long queues; discrimination by sellers
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CASE STUDY: Rent Control in the Short Run
and Long Run
• Rent controls are ceilings placed on the rents
that landlords may charge their tenants.
• The goal of rent control policy is to help the
poor by making housing more affordable.
• One economist called rent control “the best way
to destroy a city, other than bombing.”
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Figure 2 Rent Control in the Short Run and in the Long Run
(a) Rent Control in the Short Run
(supply and demand are inelastic)
Rental
Price of
Apartment
Supply
Controlled rent
Shortage
Demand
0
Quantity of
Apartments
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South-Western
Learning
Figure 2 Rent Control in the Short Run and in the Long Run
(b) Rent Control in the Long Run
(supply and demand are elastic)
Rental
Price of
Apartment
Supply
Controlled rent
Shortage
0
Demand
Quantity of
Apartments
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South-Western
Learning
How Price Floors Affect Market Outcomes
• When the government imposes a price floor,
two outcomes are possible.
• The price floor is not binding if set below the
equilibrium price.
• The price floor is binding if set above the
equilibrium price, leading to a surplus.
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Figure 3 A Market with a Price Floor
(a) A Price Floor That Is Not Binding
Price of
Ice-Cream
Cone
Supply
Equilibrium
price
€3
Price
floor
2
Demand
0
100
Equilibrium
quantity
Quantity of
Ice-Cream
Cones
Copyright
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South-Western
Learning
Figure 3 A Market with a Price Floor
(b) A Price Floor That Is Binding
Price of
Ice-Cream
Cone
Supply
Surplus
€4
Price
floor
3
Equilibrium
price
Demand
0
Quantity of
Quantity Quantity Ice-Cream
Cones
demanded supplied
80
120
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South-Western
Learning
How Price Floors Affect Market Outcomes
• A price floor prevents supply and demand from
moving toward the equilibrium price and quantity.
• When the market price hits the floor, it can fall no
further, and the market price equals the floor price.
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How Price Floors Affect Market Outcomes
• A binding price floor causes . . .
• a surplus because QS > QD.
• non-price rationing is an alternative mechanism for
rationing the good, using discrimination criteria.
• Examples: The minimum wage, agricultural price
supports
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The Minimum Wage
• An important example of a price floor is the
minimum wage. Minimum wage laws dictate
the lowest price for labour that any employer
may pay.
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Figure 4 How the Minimum Wage Affects the Labour
Market
Wage
labour
Supply
Equilibrium
wage
labour
demand
0
Equilibrium
employment
Quantity of
labour
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South-Western
Learning
Figure 4 How the Minimum Wage Affects the Labour
Market
Wage
labour surplus
(unemployment)
labour
Supply
Minimum
wage
labour
demand
0
Quantity
demanded
Quantity
supplied
Quantity of
labour
Copyright
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South-Western
Learning
TAXES
• Governments levy taxes to raise revenue for
public projects.
• Taxes discourage market activity.
• When a good is taxed, the quantity sold is
smaller.
• Buyers and sellers share the tax burden.
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Elasticity and Tax Incidence
• Tax incidence is the manner in which the
burden of a tax is shared among participants in
a market.
• Taxes result in a change in market equilibrium.
• Taxes discourage market activity.
• When a good is taxed, the quantity sold is smaller.
• Buyers and sellers share the tax burden
• Buyers pay more and sellers receive less, regardless
of whom the tax is levied on.
Copyright © 2010 Cengage Learning
Figure 5 A Tax on Buyers
Price of
Ice-Cream
Price
Cone
buyers
pay
€3.30
Price
3.00
2.80
without
tax
Price
sellers
receive
Supply, S1
Equilibrium without tax
Tax (€0.50)
A tax on buyers
shifts the demand
curve downward
by the amount of
the tax (€0.50).
Equilibrium
with tax
D1
D2
0
90
100
Quantity of
Ice-Cream Cones
Copyright
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South-Western
Learning
Figure 6 A Tax on Sellers
Price of
Ice-Cream
Price
Cone
buyers
pay
€3.30
3.00
Price
2.80
without
tax
S2
Equilibrium
with tax
S1
Tax (€0.50)
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax (€0.50).
Equilibrium without tax
Price
sellers
receive
Demand, D1
0
90
100
Quantity of
Ice-Cream Cones
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South-Western
Learning
Figure 7 A Payroll Tax
Wage
labour supply
Wage firms pay
Tax wedge
Wage without tax
Wage workers
receive
labour demand
0
Quantity
of labour
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South-Western
Learning
Elasticity and Tax Incidence
• In what proportions is the burden of the tax
divided?
• How do the effects of taxes on sellers compare
to those levied on buyers?
• The answers to these questions depend on the
price elasticity of demand and the price
elasticity of supply.
Copyright © 2010 Cengage Learning
Figure 8 How the Burden of a Tax Is Divided
(a) Elastic Supply, Inelastic Demand
Price
1. When supply is more elastic
than demand . . .
Price buyers pay
Supply
Tax
2. . . . the
incidence of the
tax falls more
heavily on
consumers . . .
Price without tax
Price sellers
receive
3. . . . than
on producers.
0
Demand
Quantity
Copyright
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South-Western
Learning
Figure 8 How the Burden of a Tax Is Divided
(b) Inelastic Supply, Elastic Demand
Price
1. When demand is more elastic
than supply . . .
Price buyers pay
Supply
Price without tax
3. . . . than on
consumers.
Tax
Price sellers
receive
0
2. . . . the
incidence of
the tax falls
more heavily
on producers . . .
Demand
Quantity
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South-Western
Learning
ELASTICITY AND TAX INCIDENCE
• So, how is the burden of the tax divided?
• The burden of a tax falls more heavily on the
side of the market that is less price elastic.
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Review
• Price controls include price ceilings and price
floors.
• A price ceiling is a legal maximum on the price
of a good or service. An example is rent
control.
• A price floor is a legal minimum on the price of
a good or a service. An example is the
minimum wage.
Copyright © 2010 Cengage Learning
Review
• Taxes are used to raise revenue for public
purposes.
• When the government levies a tax on a good,
the equilibrium quantity of the good falls.
• A tax on a good places a wedge between the
price paid by buyers and the price received by
sellers.
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Review
• The incidence of a tax refers to who bears the
burden of a tax.
• The incidence of a tax does not depend on
whether the tax is levied on buyers or sellers.
• The incidence of the tax depends on the price
elasticities of supply and demand.
• The burden tends to fall on the side of the
market that is less price elastic.
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Mini Quiz
Assume that the government sets a ceiling on the interest rate that
banks charge on loans. If the ceiling is set below the market
equilibrium interest rate, the result will be
a. a surplus of credit.
b. a shortage of credit.
c. greater profits for banks issuing credit.
d. a perfectly inelastic supply of credit in the market place.
Rent controls typically end up
a. increasing rents received by landlords.
b. raising property values.
c. encouraging landlords to overspend for maintenance.
d. discouraging new housing construction.
Copyright © 2010 Cengage Learning
Mini Quiz
In the supply and demand schedules for socks shown here, if a price floor of
€10 is imposed by the government
A) what quantity of socks will actually be purchased?
B) What will the shortage/surplus be?
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